Horses and Rabbits?  Optimal Dynamic Capital Structure from Shareholder and Manager Perspectives  

Ju, Nengjiu, Robert Parrino, Allen M. Poteshman, and Michael S. Weisbach, 2005, Horses and Rabbits?  Optimal Dynamic Capital Structure from Shareholder and Manager Perspectives, Journal of Financial and Quantitative Analysis 40, 259-281.

This paper examines optimal capital structure choice using a dynamic capital structure model that is calibrated to reflect actual firm characteristics.  The model uses contingent-claim methods to value interest tax shields, allows for reorganization in bankruptcy, and maintains a long-run target debt/equity ratio by refinancing maturing debt.  Using this model we calculate optimal capital structures in a realistic representation of the traditional ‘tradeoff’ model.  In contrast to previous research, the resulting optimal capital structures do not imply that firms tend to use too little leverage in practice.  We also estimate the costs borne by a firm whose capital structure deviates from its optimal, ‘target’ debt/equity ratio.  The costs of moderate deviations are relatively small, suggesting that a policy of adjusting leverage infrequently is likely to be reasonable for many firms.